Despite the Fed’s rate-cut campaign, medium- and longer-term interest rates in the US have risen sharply in recent months. This has weighed heavily on bond investors’ returns (as higher bond yields equate to lower bond prices). It’s also translated into higher rates on mortgages and other borrowings.
Since the Fed began cutting in September 2024, the federal-funds rate has been reduced by 100 basis points. The federal-funds target range now stands at 4.25%-4.50%, after staying at a lofty 5.25%-5.50% from July 2023 to September 2024.
But—perhaps surprisingly—medium- and longer-term rates moved in the opposite direction over the same time period. Since mid-September 2024, the 10-year US Treasury yield has increased by 100 basis points, and the two-year yield has increased by around 60 basis points.
The 10-year yield stands at 4.6% as of Jan. 24, 2025, up from a trough of 3.6% in mid-September 2024. It recently stood as high as 4.8% (on Jan. 15, 2025), not far from the cycle peak of 5.0% reached in October 2023. The 10-year yield remains far above the 2.5% average in the prepandemic years of 2017-19.
US Federal Funds Rate, US 2-Year Treasury Yield, and US 10-Year Treasury Yield
Source: Federal Reserve Bank of St. Louis.
Why Are Longer-Term Rates Not Falling Following the US Fed’s Cuts?
The federal-funds rate is an overnight rate, so it anchors the very short end of the yield curve. Fixed-income instruments with low risk and very short maturities (say, a one-month T-bill) should move virtually in near lockstep with the federal-funds rate. But there’s no guarantee the same should hold as we move further out on the yield curve.
Some investors might have expected Fed rate cuts to lead to lower interest rates across the board. This is not completely naïve. There are many historical instances of rates behaving this way, and interest rates of varying maturity do tend to share a common long-run trend. However, with a sharper understanding of monetary policy and bond pricing, we can see why rates in different parts of the yield curve have moved in contrary directions.
Via arbitrage, the yield on a long-term bond should equate to investors’ expectations of the average federal-funds rate over that same time period (plus a spread to cover higher risk). Therefore, long-term yields shouldn’t reflect what the Fed is doing today—instead, they should mainly reflect expectations of what the Fed will do in the future.
At the same time that the Fed proceeded with rate cuts in the closing months of 2024, investors were curbing their expectations of future rate cuts in 2025 and beyond. Expectations of the federal-funds rate for the end of 2025 have risen from 2.75%-3.00% as of September 2024 to 3.75%-4.00% currently. That 100-basis-point upward shift in longer-run federal-funds rate expectations is commensurate with the 100-basis-point increase in the 10-year Treasury yield.
US Federal-Funds Rate Expectations
%, Bottom of Target Range
Source: Federal Reserve, Chicago Mercantile Exchange.
In addition to the expectations perspective, we can also look at the shift in yields from the vantage point of supply and demand. Arguably, heightened concern about the US government’s debt load has curbed the demand for Treasuries, also contributing to the rise in yields.
Why Do Investors Now Expect Fewer US Fed Rate Cuts?
So, we’ve established that the runup in bond yields is explained by investors revising their expectations for the future federal-funds rate. What’s caused that expectation shift?
We can start by disaggregating the 10-year yield into two components: the real (or inflation-adjusted) 10-year yield and the implied (or “breakeven”) inflation rate over the next 10 years. The real yield is the rate on Treasury Inflation-Protected Securities, or TIPS.
Of the 100-basis-point increase in the 10-year yield since mid-September, about 35 basis points are attributable to higher implied inflation. The remaining 65 basis points are attributable to higher real yields. Thus, higher inflation expectations are playing some role in driving up interest-rate expectations, but the main driver is higher real yields.
10-Year Real Yield (TIPS) and 10-Year Breakeven Inflation Rate
Source: Federal Reserve Bank of St. Louis.
Digging further into the data, the breakeven inflation rate has mainly risen for the next five years, whereas expectations for inflation six to 10 years ahead haven’t moved much. Higher inflation expectations are likely a reaction to recent data in part. Three-month growth in core Personal Consumption Expenditures prices ticked up from 2.3% annualized as of August 2024 to 2.5% as of November 2024.
Month Over Month and 3 Month US Inflation Rate (Annualized)
Source: Federal Reserve Bank of St. Louis.
Probably the biggest driver of higher inflation expectations is higher expectations for economic growth and the strength of the labor market. A hotter economy means more upward pricing pressure. Also, the risk of tariff hikes has also factored into the market’s reckoning.
The rise in real yields means that the market no longer thinks the Fed has to ease monetary policy as much in order to maintain healthy economic growth and full employment.
The unemployment rate (three-month average) has held steady at around 4.15% in the past several months. That has eroded earlier fears that the labor market was deteriorating. The unemployment rate had drifted up from a three-month average of 3.6% as of August 2023 to 4.2% in August 2024, triggering the “Sahm Rule,” a signal that has historically indicated a coming recession.
US Unemployment Rate
Source: Federal Reserve Bank of St. Louis.
Likewise, real GDP growth has remained quite solid, expanding 3.1% in the third quarter of 2024 and likely to post in the 2%-3% range in the fourth quarter of 2024.
Mounting fears of slowing growth and rising unemployment in mid-2024 had led to a belief that the Fed would need to cut rates very aggressively to keep the economy afloat. But those fears dissipated in the closing months of 2024, driving up real yields and expectations of the federal-funds rate path.
This Time is Different: How Do the Recent US Fed Rate Changes Compare With History?
While it may be cliché to say “This time is different,” comparing the interest-rate movements observed so far with past Fed easing cycles reveals intriguing distinctions that make this cycle truly unique.
Out of the past 11 easing cycles since 1966, 10-year Treasury yields increased at the same point (approximately four months after the Fed’s first rate cut) in only three instances. On average, 10-year Treasury yields declined by 26 basis points four months into previous easing cycles. In contrast, we are currently seeing a striking 95-basis-point increase—a clear outlier.
10-year US Treasury Yield Change from First Cut to 4 Months Later in Each Past Easing Cycle Since 1966
Source: Federal Reserve Bank of St. Louis.
This sharp rise in long-term rates has led to a meaningful steepening of the yield curve, as the curve quickly transitioned from inversion to steepness. While yield-curve steepening is typical in an easing cycle, the speed and magnitude of this steepening (defined as the 10-year Treasury yield minus the two-year Treasury yield) are extraordinary.
US Treasury Yield Changes 4 Months After the First Cut
Source: Federal Reserve Bank of St. Louis.
It’s important to note that before the first rate cut in this cycle, the yield curve had been inverted since May 2023, with the magnitude of the inversion standing out compared with past cycles.
US Treasury Yield Curve Steepness
Source: Federal Reserve Bank of St. Louis.
Coming off such a prolonged and deep inversion, there remains room for further steepening even after the notable changes observed so far.
US Treasury Yield Curve Changes from Most Inverted to Peak Steepness
Source: Federal Reserve Bank of St. Louis.
What Do These US Interest Rate Trends Mean for My Portfolio?
The sharp changes and unique characteristics of this easing cycle make it imperative for investors to reassess their fixed-income allocations. Positioning should consider not only recent developments but also potential future scenarios. Given significant uncertainties about the path ahead, relying on a single forecast is risky. Instead, it’s prudent to evaluate a range of outcomes across multiple economic scenarios.
To aid investors in this effort, we’ve developed five economic scenarios that could unfold over the next 12 months. These scenarios translate into forecasted returns across US government bonds, providing a framework to assess positioning along the yield curve. Furthermore, we’ve assigned probabilities to each scenario, enabling us to interpret results through a probability-weighted lens.
1-year Simulated Returns Across Economic Scenario
Source: Morningstar.
Key Takeaways for Investors
- Cash Underperformance: Cash is expected to underperform short-term Treasuries in four out of five scenarios. While current cash rates are significantly higher than those of the past decade, moving out of cash and gaining rate exposure would likely be more beneficial for investors.
- Moderate Duration Extension: A probability-weighted analysis suggests that, despite the likelihood of further steepening, investors should consider moderately extending the duration of their portfolios to capture potential gains.
- Intermediate-Term Treasuries as a Sweet Spot: Intermediate-term Treasuries present an attractive balance. Even in the most adverse scenario—where 10-year Treasury yields increase by 100 basis points—they are still projected to generate positive returns.
- Wide Range of Outcomes for Long-Term Treasuries: Long-term Treasuries offer substantial upside in scenarios with declining rates but carry significant downside risks if inflation remains high or rises further.
By considering these insights and scenario-based outcomes, investors can better navigate the complexities of this unique rate environment while positioning for a range of potential economic outcomes.
The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.
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